Yield Farming vs. Liquidity Mining: What's the Difference?
In the constantly growing blockchain technology and crypto industry, development has been led by the Decentralized Finance (DeFi) concept. Any individual with access to the internet and a supported crypto wallet may interact with DeFi applications.
During the past few years, yield farming and liquidity mining have become popular ideas. Although both of these terms are widely misinterpreted, they are very different from one another.
The purpose of this article is to explain what yield farming and liquidity mining are and how they work, the main differences between them as well as their upsides and risks.
What is Yield Farming?
Yield farming is a way to earn extra financial rewards with crypto holdings. Basically, it refers to securing cryptocurrency and earning rewards.
Perhaps you have heard of staking. Well, staking and yield farming are similar in specific ways. In yield farming, crypto holders deposit their funds to liquidity pools in order to provide liquidity to other users. Thus these holders become liquidity providers (LPs).
It is worth mentioning that a liquidity pool is a digital pile of crypto assets locked in smart contracts. LPs are compensated for adding liquidity to the pool. The compensation could come from the DeFi platform's underpinning charges or from another source.
Some liquidity pools offer various tokens as payment methods. Once earned, the incentive tokens can be put into additional liquidity pools to continue earning rewards. However, the fundamental concept is that a liquidity provider contributes money to a liquidity pool and receives compensation in return.
Ethereum blockchain is where yield farming is commonly carried out with ERC-20 tokens, and the returns are frequently some other ERC-20 tokens. But in the future, things might be different due to evolving blockchain technology, bringing additional competitors to Ethereum. However, as of today, the Ethereum ecosystem is where much of this work takes place.
Cross-chain bridges and other related developments might, however, eventually enable DeFi apps to be blockchain-independent. This implies that they might function on different blockchain networks that facilitate the use of smart contracts.
In pursuit of high yields, yield farmers frequently switch their money between various protocols. Consequently, DeFi platforms might also offer additional financial perks to draw more funding to their system. Liquidity tends to draw in even more liquidity, much like centralized exchanges.
Now let's take a look at how this innovative idea works.
Yield farming is conducted using automated market makers (AMM), which are protocols used in liquidity pools for automatically pricing assets.
Funds are deposited into a liquidity pool by liquidity providers. Other users can borrow, loan, or trade these deposited tokens on a decentralized exchange, which is powered by a particular pool. These platforms charge additional fees, which are then distributed to liquidity providers in accordance with their percentage ownership of the liquidity pool.
Since this technology is constantly evolving, new approaches are likely to emerge and might even take over existing models.
Besides fees, releasing a new token may play a role in encouraging money to be contributed to a liquidity pool. For instance, a token might only be available in modest quantities on the open market. On the other hand, it can be generated by giving a certain pool some liquidity.
Each protocol implementation will have its own distribution rules. The bottom line is that liquidity providers get a return based on the amount of liquidity they provide to the pool.
Although not required, stablecoins connected to the USD are frequently used as the deposit method. USDT, USDC, BUSD, and other stablecoins are some of the most commonly utilized in DeFi.
Now, let's proceed further and look at what liquidity mining is.
What Is Liquidity Mining?
It is a system or a procedure where members contribute cryptocurrency to liquidity pools and are compensated with fees and tokens depending on their proportion of the liquidity in the pool. These pools include liquidity in specific crypto pairs that can be accessed through decentralized exchanges, commonly known as DEX.
Trading on DEXs is possible thanks to AMMs and liquidity pools. A liquidity pool creates a DEX market for a specific asset pair. A liquidity provider establishes the pool's opening cost and percentage, using the market to calculate an equivalent supply of both products. The idea of a balanced supply of both assets applies to all other liquidity providers who are prepared to contribute liquidity to the pool.
Smart contracts control the actions in the liquidity pool, in which each asset exchange is enabled by the smart contract, resulting in a price change. When the transaction is completed, the transaction charge is proportionately split between all LPs. The liquidity providers are rewarded accordingly based on how much they contribute to the liquidity pool.
Liquidity mining works by the following structure:
Placing your assets into a liquidity pool is the only necessary step for participation in a specific pool. It is similar to transferring cryptocurrency from one wallet to the other. ETH/USDT is an example of a typical trading pair found in pools. One of the two assets could be contributed to the pool by an investor.
An LP will obtain a more significant portion of the profits the more they contribute to a liquidity pool. Liquidity mining is based on this fundamental concept. However, different platforms approach it differently.
The difference between Yield Farming and Liquidity Mining
When implemented correctly, yield farming involves more manual work than other methods. Although cryptocurrencies from investors are still imposed, they can only be performed on DeFi platforms like Pancake swap or Uniswap. In order to help with liquidity, yield farming includes multiple blockchains, which increases the risk potential significantly.
Extra effort delivers an increased return. In addition to their regular income, yield farmers may earn token prizes and a portion of transaction cost, significantly increasing the potential APY. To sufficiently maximize their revenue, yield farmers should switch pools as frequently as once a week and constantly change their strategy. Mining liquidity makes a significant contribution to the decentralization of blockchains. The incentives earned are the crucial difference. Liquidity miners frequently receive the blockchain's native token as compensation and have the opportunity to acquire governing tokens, allowing them to participate in any framework and empower each individual.
You must do your research before becoming involved since all yield-farming and liquidity mining operations are handled via DeFi, which means you must deal with a decentralized exchange. Although the risk is considerable, the benefits can be even bigger. Here are a few examples of the most reliable DeFi platforms to use as you begin your yield farming or liquidity mining endeavor:
Now, let's take a closer look at the advantages and disadvantages of both methods.
Key Benefits of Yield Farming
You are not required to agree to a fixed lock-up duration in yield farming pools. This implies that you can change the amount of liquidity as needed. It is simple to immediately withdraw if you feel vulnerable and exposed to a particular pool. On the other hand, you can choose to invest more tokens if you discover that a specific yield farming pool is providing you with better farming conditions.
Based on the trading pair you choose, you can also be exposed to sizable yields that are more than what other methods offer. Obviously, this will vary on how volatile and liquid the pair is. For instance, there is a solid probability that the pool will offer triple-digit APYs if you want to provide liquidity for a brand-new and unknown crypto asset. Farming is widespread since it may produce double-digit returns even on very liquid pairs.
This method has the following negative aspects:
Risks of Yield Farming
Yield farming puts all participants in danger of losing money. Users run a higher risk of financial loss and price slippage during volatile markets. Here are a few concerns connected to it:
The extent to which an investment's price fluctuates in either direction is referred to as volatility. A turbulent asset can have a significant price swing in a short moment. Yield farmers take a considerable risk when tokens are locked up because of the potential for value fluctuations, especially during bearish markets.
Rug Pulls are an exit scam where a cryptocurrency creator collects money from investors for a product, abandons it, and keeps the investors' money. Rug pulls and other scams, to which yield farmers are especially sensitive, are responsible for almost every significant fraud that took place in the last couple of years.
Regulatory hazard governance of cryptocurrencies is still not clear globally. The Securities and Exchange Commission (SEC) now regulates some digital assets since it has determined that they are securities. State officials have already filed suspension and cease transactions against centralized cryptocurrency lending platforms like BlockFi, Celsius, and others. If the SEC classifies DeFi loans and borrowing as securities, the ecosystems of lending and borrowing may drop significantly.
Remember, that whole DeFi concept was specifically developed to be independent of all centralized control.
Liquidity mining and its advantages
Liquidity mining is an excellent way of earning passive income for the LPs, similar to passive stakeholders within staking networks.
This interaction approach benefits all participants in a DeFi. The platform benefits from a robust network of people, ranging from LPs and traders to designers and other intermediaries. LPs are also rewarded for lending their tokens to traders, ensuring an extremely liquid market.
A small cost of entry
Investors with smaller initial capital can easily participate in the liquidity mining process because most platforms allow minimal deposits. They also can reinvest their profits to increase their stakes in the liquidity pools.
Since everyone can engage in liquidity mining regardless of their stake, everyone has the opportunity to collect the governing tokens and use them to vote on project-related development proposals and other actions. This results in a more inclusive paradigm that allows even small investors to participate in the growth of a market.
Liquidity mining is a type of investment technique that unquestionably has several liabilities that should be appropriately considered before investing.
Risks of Liquidity Mining
Among the most severe threats that liquidity miners experience is the chance of losing money if the cost of their tokens declines when they are still locked up in the liquidity pool. Such a situation is commonly known as "impermanent loss." This loss is confirmed only when the miner withdraws the tokens at lower prices.
Scams are widespread
The prospect that the core developers behind a DeFi platform will shut the project and vanish with investors' funds is, unfortunately, quite common. One of the most significant scams happened with the Compound Finance rug pull. This scam cost investors more than 10 million USD.
Since most cryptocurrencies are open source, the source code is publicly accessible, and security issues are always likely to happen. Technical flaws could allow hackers to exploit DeFi protocols and steal finances.
To sum it up, it is evident that both yield farming and liquidity miners offer different methods for investing. The growing interest in crypto assets is unquestionably creating numerous new opportunities for investment. Nevertheless, investors must comprehend the approaches they employ to achieve the expected returns.
As a result, an understanding of the differences between yield farming and liquidity mining could help make a wise decision. Of course, you should be aware of the drawbacks and risks to yield farming and liquidity mining.
Making the best investment in a growing and ever-changing market like cryptocurrency can be challenging. Making investment decisions should be based on an investor's risk tolerance. The truth is that the higher the potential of rewards in the cryptocurrency world is, especially on DeFi, the less likely the project will be workable for a long time. Identify the factors most important to you, such as security or passivity, and build a strategy around them.